China-Japan Dispute Takes Rising Toll on Top Asian Economies

By Bloomberg News -
Jan 9, 2013

The last time a dispute between Japan
and China blew up in 2010 over eight uninhabited islands, the
economic fallout lasted less than a month. This time, the spat
is prolonging a recession in the world’s third-largest economy.

Four months after Chinese consumers staged a boycott of
Japanese products over the islands in the East China Sea, sales
of Japanese autos in China have yet to recover, Chinese
factories began to favor South Korean component suppliers, and
the U.S. has displaced China as Japan’s largest export market.

“The spats have become increasingly costly as Japan’s
dependence on China as an export market has risen,” said Tony
Nash, a Singapore-based managing director at IHS Inc., which
provides research and analytics for industries including
financial companies. “Nationalism around the issue has resulted
in lower demand for Japanese products in China and even Chinese
firms sourcing products from Korean suppliers.”

As China’s confidence in asserting its territorial claims
has grown, and trade between the two nations has tripled since
2000 to more than $300 billion, the commercial cost of failing
to resolve the dispute keeps rising. The latest flare-up came
after property developer Kunioki Kurihara sold three of the
islands to the Japanese government for 2.05 billion yen ($23
million) in September, a transaction Xi Jinping, the new head of
the Chinese Communist Party, called “a farce.”

Growth Cut

The fallout from the sale may have cut Japan’s growth in
the latest quarter by about one percentage point, JPMorgan Chase
& Co. estimated. That would be enough to keep the economy in
recession after two quarters of contraction up to Sept. 30.
Gross domestic product may have shrunk an annualized 0.5 percent
in the final three months of 2012, according to the median
forecast in a Bloomberg News survey.

The standoff over the islands known as Senkaku in Japan and
Diaoyu in China contributed to declines in Japan’s shipments to
China for six months through November. Japan’s industrial output
fell 1.7 percent in November, to the lowest level since the
aftermath of the 2011 earthquake.

With each round of political disputes, the economic effect
has grown. When then-Japanese Prime Minister Junichiro Koizumi
visited a Tokyo shrine where war criminals are among those
honored in 2005, Chinese people and politicians protested. Yet
trade between the two rose more than 12 percent that year.

Things got worse in 2010, when a Chinese fishing boat and a
Japanese Coast Guard vessel collided in contested waters. China
stopped granting export licenses to Japan for rare earth metals,
necessary for automobile and electronics industries. The
licenses were resumed about a week later after Japan released
the detained captain of the vessel.

Biggest Effect

This year’s row has had the biggest effect so far, said
Professor June Teufel Dreyer, a specialist in Chinese politics
at the University of Miami in Florida. After the Japanese
government bought the three islands, angry Chinese boycotted
Japanese products and smashed Japanese shops in China.

“This has really changed things, unquestionably; it is not
a blip,” said Dreyer. “China will continue to push its claims
to sovereignty until Beijing gets what it wants.”

The islands offer the prospect of rich fishing grounds,
potential oil reserves and a strategic military outpost in the
sea between China, Japan and Taiwan. That’s overshadowed
economic ties that Jesper Koll, head of equity research at
JPMorgan in Tokyo, called “a match made in heaven.”

“Japan has intellectual property, brands and capital,
while China has people, markets and purchasing power,” said
Koll, in an interview.

Ishihara’s Offer

The latest spat began in April when then-Tokyo Governor
Shintaro Ishihara said he planned to use public money to
purchase Kurihara’s islands. Ishihara, 80, is a longstanding
critic of China, so the national government stepped in to buy
the islands instead, in a failed attempt to defuse Chinese
anger.

China’s official Xinhua news agency on Dec. 2 criticized
the U.S. Senate’s approval of an amendment to show the islands
fall under a U.S.-Japan defense treaty, calling it a
“disturbing message” to the world that the Senate is seeking
an escalation of tensions between China and Japan.

“The row has changed the landscape of China-Japan
relations,” said Taylor Fravel, a professor at Massachusetts
Institute of Technology who specializes in Chinese politics.
“As a territory dispute, it’s prone to spirals of escalation.”

Election Win

The election victory of Shinzo Abe’s Liberal Democratic
Party, which returned to power in a landslide victory in
December, has further stoked the conflict. In its manifesto, the
LDP proposed strengthening the nation’s military and said it
would consider stationing officials on the islands, prompting an
editorial in the China Daily newspaper on Nov. 26 that described
the manifesto as “dangerous.”

Two days before the election, China sent an 11-page report
to the United Nations arguing that the geology of the
continental shelf makes the islands a natural part of China.

Japan yesterday said the government summoned the Chinese
ambassador to protest the presence of four surveillance ships
near the islands. China responded that the ships were conducting
normal duties around Chinese territory, Foreign Ministry
spokesman Hong Lei said at a briefing in Beijing.

Japan’s Defense Ministry made a budget request Jan. 7 for
extra PAC-3 missile interceptors and upgrades for F-15 fighter
planes, and will seek to raise next fiscal year’s defense budget
by about 120 billion yen, reversing the downward trend of the
last decade.

Economies Lose

“As Japan’s politics turn decisively to the right, more
and frequent spats between Japan and China are expected,” said
Liu Li-Gang, chief economist for Greater China at Australia and
New Zealand Banking Group Ltd. who used to work for the World
Bank. “Both economies will lose in the end. Japan will lose a
big market, and China will not be able to leverage on Japan’s
technology and investment for growth.”

Japanese automakers’ share of the Chinese market slumped to
14 percent in November from about 23 percent before September,
Xu Changming, a director at China’s State Information Center,
said on Nov. 29. Toyota Motor Corp. (7203), Japan’s biggest carmaker,
said in November that output in China fell the most in at least
a decade, while Nissan Motor Co. (7201) reported the biggest output
decline since at least 2009.

All Nippon Airways Co. (9202), Japan’s largest airline, had 46,000
seat cancellations on flights between September and November
because of the dispute, spokesman Ryosei Nomura said. The
carrier forecast the row will cut sales by about 10 billion yen.

“We closed stores in areas that could have been dangerous,
such as near the Japanese embassy in Beijing,” she said.

Anti-Japan protesters attacked three department stores in
Hunan province run by Heiwado Co. (8276), a supermarket operator based
in Shiga prefecture, central Japan, forcing the company to close
its stores there for more than a month and incur losses of
around 500 million yen, according to spokesman Tomoharu Tsuda.

Oil Resources

While Japan has administrative control over the islands,
they were largely ignored from the end of World War II until
1969, when a United Nations commission said the surrounding
seabed may be “extremely rich” in oil. That brought
sovereignty claims in the following years by China, Japan and
Taiwan.

“As existing resources are exhausted, the importance of
oil and gas resources in the South China Sea will increase and
that’s one of the key reasons why this issue is not going
away,” said Hao Hong, managing director of research at Bank of
Communications Co., China’s fifth-largest lender by assets.
China is “stronger than Japan militarily and economically.”

Underlying the border dispute is a history of strained
diplomatic ties between the two countries dating back to the
Japanese invasion of China in 1937 and atrocities carried out in
the country by some Japanese troops.

With political capital to be gained by both sides from
courting nationalist fervor -- Abe visited the same shrine as
Koizumi in October -- lawmakers may manipulate the row to fit
their agendas despite the economic costs, said Ding Xueliang, a
professor at Hong Kong University of Science and Technology, who
teaches contemporary Chinese politics.

Chinese Anger

“Japan is always a convenient target for the Chinese
government to use to divert domestic anger,” Ding said.
“Compared to the political values, the trade values with Japan
are secondary.”

China would be willing to accept a 30 percent reduction in
trade with Japan before it would back down, whereas Japan’s pain
threshold is about 20 percent, Ding estimated.

One possible course follows the policy proposed by the late
Chinese leader Deng Xiaoping, said Martin Schulz, a senior
economist at Fujitsu Research Institute in Tokyo.

“China knows it will never get the islands, and Japan
knows that China will never let go,” said Schulz, who has done
research for the Bank of Japan. “Deng Xiaoping’s stance from
the 1970s, to keep it quiet until joint economic cooperation in
the area becomes possible, remains the only solution.”

U.S. Relations

As the current stand-off pushes Japan and China to reduce
reliance on each other, U.S. relations with both sides could
benefit, according to Liu at ANZ Bank.

“The U.S. will become more important to both China and
Japan and will play a big balancing role between Japan and
China,” Liu said. “Japan may increase its investment in
Vietnam and other economies” in the Association of Southeast
Asian Nations.

Exports from Japan to 10-member Asean grew nearly 50
percent in the decade through 2011, according to finance
ministry data.

“Japanese investors will accelerate their strategy of
diversifying investments to the rest of Asia,” said Tao Dong,
head of Asia economics excluding Japan at Credit Suisse Group AG
in Hong Kong. “We see increased cases of Japanese investment in
Vietnam and the Philippines and there’s lots more to come.”

Acquisition Spending

Japanese companies have spent or plan to spend more than
$10 billion since January 2011 on acquisitions in the Asean
bloc, data compiled by Bloomberg show. In November, Kirin
Holdings Co. bid $2.2 billion for Singapore-based Fraser & Neave
Ltd.’s food and beverages unit.

China, which also has disagreements with Asean nations over
islands in the South China Sea, was warned last month by Vietnam
not to apply economic force to settle disputes.

“Japanese business influence in China will start to
decline” as China invites more European and U.S. investment,
ANZ’s Liu said in an interview in Tokyo. “Japanese firms’ space
in China could be limited in the future.”

Still, the legacy of decades of investment in China make it
unlikely that Japanese companies will withdraw, said Nash at
IHS.

“This is not an either-or issue,” Nash wrote in an e-
mail. “Firms will stay in China and they will invest in
Southeast Asia and other places. It’s hard for Japanese exports
to move totally away from China and it’s hard for Chinese OEMs
to move totally away from Japanese components.”

Japanese companies such as Nissan employed 1.6 million
people at subsidiaries in China in the fiscal year ended March
2011, according to the Japanese trade ministry.

As Richard Koo, chief economist at Nomura Research
Institute Ltd., wrote in a Dec. 11 report: “No matter how
unpardonable China’s behavior over the issue of Senkaku Islands
may be, as a practical matter Japan needs to proceed carefully
given the magnitude of its Japanese investments in the
country.”